As of September 21st, the Federal Reserve has recently released a statement announcing an increase of interest rates by 75 basis points. For some, it doesn't mean much. For startups and the world of private equity, CFOs and funds begin ideating new financial strategies to work around the new development.
The Federal Reserve, or Fed, is an organization that is responsible for managing monetary policy – what kind of money we have in circulation – and regulating financial institutions. The Fed has been criticized for being too weak on the first point and overly aggressive on the second. Regulators are not to be confused with money printers. They are there to ensure a level playing field for all participants in financial markets, from banks to investors.
There are two main reasons why this increase in interest rates is important for private markets:
The Fed has a history of being reactive and not proactive. Interest rates are not constantly going up and down due to the whims of central bankers. When the Fed hikes, it means that an ideal growth rate has been achieved, so high inflation should be expected. When interest rates are at all time low, it can signal that there is higher than ideal unemployment or a slowdown in the economy – neither of which is good for private market players. This increase may seem small, but remember that this makes the current fed funds rate 2% – if we have another 0.25 hike next year, we're back to normal interest rate policy.
Private equity and other private market players have a hard time investing in companies that do not have sustainable and predictable cash flows. Any company's performance can be predicted to some degree based on its history and track record, but this interest rate increase will likely cause a great deal of volatility in the economy. Most businesses cannot withstand these changes without significant help from their financiers. Investors will be more cautious than usual when dealing with young companies, since they have little to no track record and are therefore potentially much riskier. When factoring up their capital structure, investors will most likely demand larger amounts of equity to offset the risk of financing young companies with high growth potential – that is, if they decide to work with them at all.
On the other hand, higher interest rates pose a benefit to private equity investors. Because the cost of capital (interest) is higher, the overall exit multiple is also higher. If a company's value at exit can be predicted to be higher because of these conditions, a P/E ratio that factors in the effect of interest rates will give investors more bang for their buck.
The key takeaway here is that while private equity and other private market players may have to come up with new strategies to work through this increase in rates, it can also have its upsides. The Fed has been wrong in the past and may very well continue to be so. Only time will tell if this hike will cause a slowdown or if it was effective enough to speed up growth.
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